Forward guidance

Delphic or Odyssian?

Can the government rely on the Bank of England to keep Britain's recovery going? We are inviting experts in the field to comment. On Monday Kevin Daly argued in favour of forward guidance. On Tuesday John Van Reenen set out some troubling trends underpinning growth in the UK. On Wednesdday Jens Larsen called for a simple form of monetary-policy guidance. This morning George Buckley of Deutsche Bank gave a warning about the risks of guidance. Tony Yates, an academic at Bristol University who was previously a Bank of England official sets out his views next.

FOLLOWING recent forward guidance by the Bank of Canada and the Fed, attention is switching to the Britain, where markets await the Monetary Policy Committee’s response to the UK Treasury, which instructed it to assess whether it should be doing the same. Should they?

First, what is forward guidance? Central bank economists recognise two subtly different types. The first we might call Delphic forward guidance, pioneered by the Reserve Bank of New Zealand. This is simply publishing forecasts of what you think you will do with your instrument (the short term interest rate) given how you think the economy will evolve. The RBNZ have been doing this for more than 2 decades.

The second, which Charles Evans and coauthors dubbed Odyssian forward guidance, is what’s engaging central bank attention now. The short term rate has a natural floor at zero. At the ‘zero lower bound’ as it’s called, if you want to stimulate the economy further, you have to find another tool. Forward guidance at the zero bound is trying to convince markets that once the economy eventually recovers, you won’t move interest rates around as you did historically. Instead you will wait for longer before responding to rising inflation and growth. If they believe that you can tie your hands (and only if they do) then their forecasts of interest rates tomorrow will be lower. And that will lower longer term interest rates: so the rate you have to pay on a loan that you won’t pay back until after tomorrow falls today! This in turn will raise the disposable income of borrowers, encouraging more spending, activity, and inflation.

Pros and cons of Delphic forward guidance

In my view, it’s pretty hard to argue against old fashioned forward guidance. This is just being clearer about what you are doing as a policymaker, trying to find ways to communicate how you will react to events as they come along. In the jargon, its about explaining your reaction function. If it works, it should reduce uncertainty about future interest rates, allowing people to put fewer resources aside to guard against nasty interest-rate surprises. And it should help the process of holding the central bank to account. This may be a good thing in itself. It is information the population at large have a right to: they have delegated the responsibility for monetary policy to an unelected body, and should be armed with all that is necessary to monitor whether the central bank is doing what it is supposed to.

But there are economic benefits too. With sharper scrutiny possible about why the central bank is changing its mind, everyone, central bank and markets included, knows that it is harder to hide incompetence or a move in the goalposts (British soccer-speak for a breaking of a monetary policy promise). And that should reinforce the expectation that these things won’t happen, reducing interest rate and inflation uncertainty further.

In central bank circles, you hear doubts expressed about publishing interest-rate forecasts. Some worry about an unsophisticated media misinterpreting an interest-rate forecast for a promise that interest rates will follow the announced path come what may. Another argument I heard was that people may struggle to understand why the central bank, if it can set interest rates at the level it chooses, can’t simply follow the path it forecast. An argument I came across that had more bite was: how would a group of policymakers agree a vote on a whole plan? They have to vote on not just one rate, but a whole sequence of rates right out until the end of time. My rather unscientific feeling about this is that this is one of those things that would work in practice more easily than in theory (to borrow the old joke about economists). Many large organisations are effectively run by groups of managers who have to agree plans for not just one variable like interest rates, but investment spending, prices, hiring, dividends, new product launches and so on. They seem to manage. In my view the concerns about old-fashioned forward-guidance are far outweighed by the benefits.

New-fangled forward guidance:

The arguments for and against new-fangled forward-guidance are less clear cut in my view. First, it is by no means clear to me that any more monetary stimulus is needed now. We have had high and stable inflation throughout the financial crisis. Although output plummeted, and is somewhere around 15%, perhaps more, below what it would have been had the economy grown at its pre-crisis average, the fact that inflation did not fall is one way of judging that the economy’s supply capacity fell precipitously too. Why is not clear. But there are plenty of arguments to be made about the possible effects of the sclerotic financial system on productivity. The upshot is that more monetary stimulus would only boost output temporarily. The mention of ‘escape velocity’ in Carney’s utterances in this context is not right. The implication of the ‘escape velocity’ view is that a monetary jolt will somehow lift the economy onto a higher path. But most of the monetary policy models we know and love don’t behave like that. (They may be wrong of course, but if they are, they may be wrong in ways that completely invalidate our understanding of how interest rates work and thus any argument for forward guidance anyway). Instead, mainstream views of monetary policy and the economy would suggest that we would need ever looser monetary policy to sustain output at a higher level, bringing with it ever higher inflation. Even talking about doing this risks worrying markets that policy will return to the days of the 70s, when many thought that you could buy permanently lower unemployment with higher inflation.

But even if you were persuaded that more stimulus was needed--I accept there’s at least a debate to be had about this—it is not clear that forward guidance is going to work.

For a start, why should anyone believe the promise about interest rates? The yield curve is underpinned by predictions of what you are going to do with interest rates. It is where it is because people guess that once inflation and real activity start to pick up, central banks will take fright and raise rates. Once the benefit of making the promise not to do this has been pocketed (an earlier and stronger recovery) there is nothing binding the central bank to the promise, (keeping the hands tied to the mast) except the worry that such promises won’t be believed again.

On top of this, the way central bankers have come round to believing in Odyssian forward guidance is not great. Academics came up with this idea years ago. For example, in a 2003 paper Gauti Eggertson and Michael Woodford argued that holding rates at the zero bound for longer than would previously have been guessed is just the consequence of following through on a previous commit to a path of interest rates. Importantly, those plans would work just as well away from the zero bound as at it. Today’s central bankers ignored this advice until they got into trouble and actually hit the zero bound. There were good reasons for ignoring it (what kind of commitment would you implement?) but it’s unfortunate that it looks like central banks didn’t want to try commitment until it suited them. Eggertson and Woodford’s policy recommendation was about prevention. Today’s forward guidance would be an attempt at a cure--more than 3 years into a zero bound episode. With the yield curve relatively flat it may take a promise to keep rates at their floor for a very long time (a few years?) to make any appreciable difference to long interest rates. And such promises would be complicated by the fact that the membership of monetary policy committees turns over slowly. Even Mr Carney will be gone in 5 years. Not to mention that Carney was himself accused of untying his hands to follow the siren calls of the recovery and renege on his forward guidance promise in Canada. He rebuts that firmly, but then he would, wouldn't he?

Central banks hope that by announcing thresholds for things they care about (like inflation and unemployment) which must be breached before rates would lift off from the zero bound, this will help make the promise harder to break. It might work. But these thresholds are calculated in a position of great ignorance. There is huge uncertainty about the natural rate of unemployment and about how inflation expectations would react. And the models available to inform a decision about how much forward guidance is needed are being stretched to their limits and put to uses for which they were not designed. Amidst all this uncertainty, there would be many reasons for a policymaker to disregard thresholds, perhaps hoping that the zero bound episode would be a one-off, and in the face of the more pressing concern of once again rising inflation. And perhaps everyone will figure this out too and the thresholds will not help.

But even though I worry about the efficacy of Odyssian forward guidance in the UK, I think they could have a helpful legacy. Once interest rate forecasts were made at the zero bound, it would be hard to stop publishing them later on. The new fashion would actually lead to a system incorporating old-fashioned, RBNZ-style, Delphic forward guidance. I can’t think of many acts to raise transparency in central banking that were later reversed. And that would be beneficial, strengthening accountability mechanisms at a time when there is sensitivity about a Bank of England with newly enlarged powers and responsibilities. It would also help educate central bank watchers (and, I wager, even some central bankers) that monetary policy making is about setting plans for interest rates, and not just setting one rate at a time.

Readers' comments

Central bankers should not be expected to read into crystal balls or tea leaves, but to exploit their insider status and give some sensible information about the future. Leading economic indicators such as purchasing managers surveys do just that. Corporate executives have also provided this kind of "forward guidance" on earnings when releasing quarterly results, though less so since their forward-looking statements incurred some compliance problems.
Star central bankers have taken up the art of looking ahead, with seemingly no concerns so far about disclaimers. Posing as Delphic, Odyssian or Zen-like oracles(better not to mention Cassandra) adds to their aura of sacrality but misses the point. And yet the continuos delays in Europe's economic recovery, so often predicted maybe to soothe people, should dismiss their divine nature.